Return on invested capital (ROIC)

How can an outsider judge capital allocation?

Inside the company, managers judge projects with forecast cash flows (NPV and IRR). An independent analyst has none of those forecasts. What the analyst has are consolidated financial statements, and sometimes segment data, which blend the cash flows of many projects.

From these an analyst can compute return on invested capital (ROIC) , also known as return on capital employed . It measures the profit earned per unit of the total capital management has invested, usually over a year.

How do you calculate ROIC?

ROIC divides after-tax operating profit by the capital that funds the business. Three details matter, and the exam tests all of them.

• After tax. After-tax operating profit is operating profit times one minus the tax rate.
• Average capital. Profit is earned across the year, so use the average of the opening and closing balances.
• Long-term funding only. Invested capital is long-term liabilities plus equity. Short-term liabilities (working capital items) are not included, because invested capital measures the total capital investment.

$$\text{ROIC} = \frac{(1-t)\times \text{Operating profit}}{\text{Average (long-term liabilities + equity)}}$$

Go deeper Practitioner adjustments to invested capital

There is less agreement on how to measure ROIC than on, say, the operating margin, especially the denominator. Many practitioners subtract intangible assets and excess cash from invested capital, and leave out long-term liabilities such as pension and deferred tax liabilities. Treatment of one-off expenses, leased assets and non-controlling interests also varies. On the exam, use the formula as given. When comparing sources, check which definition each uses.

Profitable investments can also depress ROIC for a few years: the capital arrives in the denominator at once while the profit builds slowly.

What drives ROIC?

ROIC splits into two ratios that you can read from the income statement and the balance sheet.

$$\text{ROIC} = \frac{\text{After-tax operating profit}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Average invested capital}}$$

The first ratio is the after-tax operating profit margin : how much profit each unit of sales leaves. The second is capital turnover : how much sales each unit of capital produces. So there are two routes to a higher ROIC, a fatter margin or a higher turnover. A high-margin company can still earn a low ROIC if its turnover is low, and a thin-margin company can earn a good ROIC if its turnover is high.

ROICafter-tax operating profit ÷ average invested capital

• After-tax operating margin Memorize after-tax operating profit ÷ sales
  • Higher prices or lower costs fatter margin
  • Lower tax rate more profit kept
• Capital turnover Memorize sales ÷ average invested capital
  • More sales from the same capital higher turnover
  • Same sales on less capital higher turnover

Is the ROIC good enough?

Compare ROIC with the return investors require. Because ROIC is earned on debt and equity capital together, the benchmark is a blended required return on both. Equity is riskier than debt, so its required return is higher; using the cost of equity alone would set the bar too high. The next module shows how to build the blended figure (the weighted average cost of capital).

If ROIC stays above the blended required return over time, the company creates value for investors. Valmont’s 10.7% beats a blended 8% by 2.7 percentage points. If ROIC is persistently below it, management should return capital to investors or look for better uses.

How does ROIC differ from NPV and IRR?

	NPV / IRR	ROIC
Level	a single project	the whole company (or a segment)
Data	internal forecasts, not public	published financial statements
Basis	cash flows	accounting profit
Time	forward looking	backward looking, one year at a time
Weakness	needs non-public forecasts	can be volatile, masks good and bad units, definitions vary

ROIC limitationsan aggregate, accounting-based measure

• Accounting, not cash Use it operating profit differs from cash flow
• Backward looking Use it volatile year to year; new projects take years to pay
• Aggregated Use it can mask good and bad business units
• Definitions vary Use it treatment of intangibles, excess cash, leases

Because ROIC is volatile, analysts study its trend and rate of change, not one year in isolation.

Exam tip NPV and IRR tell management what to do next. ROIC tells an outsider how well management has done so far.